Saturday, May 16, 2009

The principal cold gale causing green shoots to wither will probably be the inexorable rise in long-term interest rates. This has already begun; the 10-year Treasury yield is up from its low of 2.07% in December to around 3.3% today. However, the enormous Treasury financing requirement and the increasing visibility of inflationary signals will cause yields to go much higher. In the 1990s, when average inflation was 2.9%, the same level as the recently announced first-quarter GDP deflator, and the federal budget deficit averaged a mere 2.3% of GDP, the 10-year Treasury yield averaged 6.67%. That level may seem very high currently, but in fact is likely to be passed fairly rapidly, on the way to Treasury bond yields of 10% or more as deficits and inflation provide a howling adverse gale for the T-bond market. The rise in interest rates will be prolonged and initially quite slow, but we can probably expect 10-year Treasurys to yield more than 6% a year from now.

If rising interest rates are the gale causing green shoots to wither, inflation will be the frost causing them to die. Federal Reserve Chairman Ben Bernanke has enjoyed a period in the public eye, even before his January 2006 ascension as Fed chairman, largely punctuated by self-delusion on an extraordinary scale. It began with his discovery of a hitherto undetected dire deflationary threat in 2002, continued with his announcement of the "Great Moderation" in February 2004, just as his lax monetary policy was sending housing policies into orbit, continued with his accusation that evil Asian savers had caused the 2007-08 explosion in commodity prices and has now settled into an indelible conviction that, however "unorthodox" and Weimarite his monetary policies may be, inflation is far less of a danger than deflation.

It will be a race between soaring interest rates and grimly rising inflation to kill the green shoots of recovery and plunge the U.S. economy into renewed downturn. Both factors will reinforce each other as buyers of Treasury bonds, appalled by the price declines in their holdings, will come to realize that inflation as well as soaring interest rates has made long-term Treasurys the ultimate sucker's bet. Zhou Xiaochuan, governor of the People's Bank of China, will no doubt be especially withering in his condemnation, discovering a hitherto little-known treatise on sound monetary policy in his copy of the "Thoughts of Mao Zedong."